Valuation on Woolworths Limited

FINC2011 Major Assignment

Woolworths Limited Valuation Report

440067960

Executive Summary

This report provides an analysis of the valuation of Woolworths Limited. Some basic information of the company is introduced in the first part. After that, the company’s historical share prices, with monthly interval over a period of 5 years from 1 May 2010 to 1 May 2015, are used to calculate the beta. The All Ordinaries Market Index and 10-year Australian Government Bond rate are applied as the market rate and risk-free rate in this calculation, which gives the outcome of 0.4467. This is then compared to the beta of 0.67 published by Morningstar, together with the identification of several factors that contribute to the difference. These factors include the choice of time frame, the choice of interval, the choice of different methods used, and the proxy of market rate and risk-free rate. In part 3, by using the CAPM model, a discount rate of 0.0817 is determined for the company. In addition, justification of the assumptions made is also presented. The following part estimates the dividend growth rate using the dividend discount model and gets a result of 0.0325. Reasons for whether this outcome is appropriate or not are specified based on two perspectives. It can be argued as a reasonable estimate when referring to the historical growth rate and considering the dividend and EPS stability, but when looking into the forecasted earnings in the near future, it’s inappropriate to assume a constant growth rate like this. A much smaller estimated growth rate is considered more appropriate. In the final part, three comparable companies of Woolworths are picked in order to value the company. The average P/E ratio is calculated and applied in the measurement of the company’s price per share and total value. However, as the method of comparable has some limits and the outcome is a lot different from the actual number, the valuation is considered as inappropriate.

1. Company selection and introduction

In this report, Woolworths Limited is selected from the ASX 200 list for the purpose of valuation. It was first listed on Australian Security Exchange market on 23 July 1993 and the ASX code is WOW (Australia Security Exchange Market 2015). Woolworths Limited is a retailer with primary activities in Supermarkets and some other operations including BIGW discount department stores, Home Improvement, Petrol through the Woolworths/Caltex alliance; and Hotels (DatAnalysis Premium 2015).

2. Calculation and Comparison of Beta coefficient

According to the CAPM model, beta is the coefficient measuring the stock price's sensitivity to fluctuations of the market as a whole, in other words, the risk of exposure to general market movement (Brealey, Myers and Allen 2014). A beta greater than one indicates greater volatility whereas a beta less than one indicates lower volatility than the market. To estimate the beta, historical share prices of Woolworths Ltd over a 5-year period are quoted (Yahoo Finance 2015a) and the All Ordinary Accumulation Index (Bloomberg 2015) as well as the return on 10-year government bonds (Reserve Bank of Australia 2015) are applied. All of the data collected are justified as below.

Sample interval:

Historical share prices of monthly interval are chosen for estimating beta here because high-frequency data such as daily or weekly share prices may lead to systematic biases as the price fluctuates between bids and ask prices while the stock’s intrinsic value remains unchanged in such a short interval (Koller, Goedhart and Wessels 2010). Moreover, returns measured over a short interval, especially daily returns, may ‘suffer from non-synchronous trading problem which results in serial correlation in returns’ (Kim 1999). In contrast, lengthening the measurement interval can help smooth out this noise, and thus is more likely to provide stable and reliable estimates of beta. Besides, since using yearly or quarterly data may not generate sufficient observations in the sample unless the estimation period covers at least previous 20 years, monthly interval is more appropriate in collecting historical data.

Sample time frame:

The historical share prices used in this calculation are over a period of five year from 1 May 2010 to 1 May 2015. According to Gonedes’s (1973) and Kim’s (1993) findings, betas estimated based on the choice of a five-year period tend to be reasonably stable, as ‘it is a satisfactory trade-off between a large enough sample size which enables reasonably efficient estimation and a short enough period over which the underlying beta could be assumed to be stable’. In additions, sufficiently large sample and the use of recent data are also argued to be required for reliable estimation of beta, since ‘lengthening the estimation period may increase the likelihood that structural characteristics of the firm have changed, leading to a change in beta’ (Daves, Ehrhardt, and Kunkel 2000).

Market rate ()[pic 1]

All Ordinary Accumulation Index is applied here as the appropriate market rate for the reason that it approximately accounts for 77% of the Australian equity market and consists of the 500 largest ASX listed companies by way of market capitalization (Market Index 2015), while the ASX 200 only covers the top 200 listed corporations and thus is an insufficient proxy for market rate. Furthermore, the All Ordinary Accumulation Index assumes the reinvestment of dividend, which is more appropriate to represent the actual market rate of return (ASX 2015).

Risk-free rate ([pic 2]

In practice, government-backed security is a commonly accepted proxy for the risk-free asset, because such securities may carry some but very low risk of default. As a result, the rate on domestic government debt provides a close proxy for the risk-free rate (Lally 2000). Despite no default risk, the other requirement for an asset to be risk free is having no reinvestment risk (Damodaran 2010). Short-term fixed income securities such as Treasury Bills may increase exposure to reinvestment rate risk while longer-term bonds tend to be a good hedge against reinvestment rate risk (Manning & Napier 2014). Hence, the 10 years Australian government bond rate is chosen here as the risk-free rate.

Calculation

The formulas in relation to the calculation of beta are given as follow.

[pic 3]

 = the beta of security i[pic 4]

= covariance between excess returns on the stock and excess returns on the market[pic 5]

= the variance of the excess returns on the market[pic 6]

Where   [pic 7]

[pic 8]

[pic 9]

Since the close price adjusted for dividends is used here,  

[pic 10]

Using excel technology, [pic 11]

                      [pic 12]

Therefore,              [pic 13]

(The data used and the detailed working can be seen in the appendix.)